On September 29, 2006, the Federal Reserve and the other federal financial
institutions regulatory agencies issued the attached Interagency Guidance
on Nontraditional Mortgage Product Risks. This guidance addresses both
risk management and consumer disclosure practices that institutions should
employ to effectively assess and manage the risks associated with residential
mortgage loans that allow borrowers to defer repayment of principal and sometimes
interest (referred to as nontraditional mortgage loans). Attachment 1
provides the Federal Register notice.1
Attachment 2 provides the interagency guidance. At the same time, the
agencies are also issuing an addendum to the 2005 Interagency Credit Risk
Management Guidance for Home Equity Lending2
to provide additional guidance to regulated institutions on consumer disclosure
practices for open-end home equity lines of credit that contain interest only
features. Refer to Attachment 3.

Guidance on Nontraditional Mortgage Products

Given the potential risks associated with nontraditional mortgage products,
the guidance addresses both risk management and consumer disclosure practices
that institutions should consider in their mortgage lending activity. For
purposes of this guidance, nontraditional mortgage loans include both "interest-only"
mortgages, where a borrower pays no loan principal for the first few years
of the loan, and "payment option" adjustable-rate mortgages (ARMs),
where a borrower has flexible payment options with the potential for negative
amortization. A borrower's payment on a nontraditional mortgage loan can increase
significantly when the loan begins to amortize, leading to what is commonly
referred to as "payment shock." Payment option ARMs carry greater
potential payment shock if a borrower makes only minimum payments, resulting
in negative amortization.

Risk Management Practices: The guidance highlights the key
risk areas that should be addressed by an institution in its underwriting
standards, loan terms, borrower qualification standards, documentation
requirements, and portfolio and risk management practices. In particular,
the agencies expect an institution's borrower qualification criteria to
include an evaluation of a borrower's repayment capacity and ability to
repay the debt by final maturity at the fully indexed rate, assuming a
fully amortizing repayment schedule. The criteria should include a credible
analysis of a borrower's capacity to repay the full amount of the credit
extended, including potential negative amortization. Recognizing that an
institution's underwriting criteria are based on multiple factors, an institution
may develop a range of reasonable tolerances for each factor used in the
borrower qualification process, such as loan-to-value ratios, debt-to-income
ratios, and credit scores. These tolerances should be based on prudent
and appropriate underwriting standards, taking into account both the borrower's
characteristics and the loan product's attributes.

Consumer Disclosure Practices: Institutions
are reminded that consumer disclosures on these types of mortgage products
must comply with applicable consumer laws. In light of the risks that these
products pose to consumers, the guidance also contains recommended practices
for an institution to consider when providing information to consumers on
the product's terms (including the existence of any prepayment penalty
or premium to be paid for reduced documentation loans) and risks (including
the risk of payment shock and negative amortization). Such information should
be provided to consumers at critical decision-making points, such as when
a consumer is shopping for a mortgage or is deciding which monthly payment
option to choose in a particular month. Since open-end home equity lines of
credit (HELOC) with an interest-only feature may pose risks to consumers
similar to those of closed-end mortgages, the agencies are also issuing an
addendum to the 2005 Interagency Credit Risk Management Guidance for
Home Equity Lending to address the timing and content of consumer communications
for interest-only HELOCs.

Federal Reserve Banks are asked to distribute this letter, the interagency
guidance, and addendum to the HELOC guidance to banking organizations supervised
by the Federal Reserve, as well as to their supervisory and examination staff.
If you have any questions concerning the safety and soundness sections of
this guidance, please contact Sabeth Siddique at (202) 452-3861,
Virginia Gibbs at (202) 452-2521, or Brian Valenti at (202) 452-3575
in the Board's Division of Banking Supervision and Regulation. For questions
related to consumer disclosure practices, please contact Anjanette Kichline
at (202) 785-6054 or Kathleen Ryan at (202) 452-3667 in the
Board's Division of Consumer and Community Affairs.